Credit Enhancements in Leasing Transactions
I. Credit Enhancements
1. Introduction/Overview:
(a) What are credit enhancements? Additional security or other assurance of the tenant’s ability to fulfill its obligations under the Lease. [Landlord’s ability to trust that IN THE FUTURE the tenant will meet its payment obligation, in exchange for RIGHT NOW locking up the leasing right in the space.]
(b) Why are credit enhancements used?
(i) Expand pool of possible tenants beyond just entities that, based solely on their financials, meet the Landlord’s underwriting requirements.
(ii) They reduce risk to the Landlord, in the event the Tenant’s economic condition deteriorates.
2. Standard Credit Enhancements:
(a) Cash Security Deposits
(b) Guaranties
(c) Letters of Credit.
(d) Lease Bonds, Pledges of “other collateral”, and the Landlord’s Statutory Lien.
3. What makes for a “good” credit enhancement, from LL perspective
(a) “Value” of the enhancement (amount of money backstopping the lease obligations OR, for non-cash credit enhancements, the amount of money backstopping the pledge to pay);
(b) Ease of conversion to cash / ease of enforcement;
(c) Ease of administration by Landlord and its property manager;
(d) Likelihood of the use or enforceability of the credit enhancement being substantially affected by a bankruptcy filing by the tenant. What happens to the credit enhancement if your Tenant files for bankruptcy? What happens if the Guarantor files for bankruptcy?
(i) Two primary issues to keep in mind with respect to a tenant bankruptcy, and your ability to make a claim on the credit enhancement in landlord’s possession:
(A) Automatic stay: Stay on (i) enforcement of judgments against the filing debtor, (ii) acts to obtain possession of debtor’s property, (iii) create or enforce liens against the debtor’s property, or (iv) setting off debts owing against the debtor. Bankruptcy court does not want a run-on-the-bank type of situation by the creditors against the filing debtor.[1]
(B) Cap on claim: For landlords under leases, there is a limit on the damages that can be recovered, in connection with the termination of a lease of real property by a tenant who has filed for bankruptcy.
1. Landlord’s claim for lease termination damages is limited to the sum of (1) rent due as of the filing of the BR petition (or date of lease termination if earlier termination occurs) without acceleration, PLUS (2) greater of (A) one year’s rent (calculated without reference to accelerated rent) and (B) 15% of the rent due for the remaining term of the lease (not to exceed 3 years).[2]
4. Cash Security Deposit: Because of their simplicity and prevalence, cash security deposits should be considered a baseline comparison point when considering other credit enhancement options.
(a) What is a cash security deposit?
(i) Sum of cash held by Landlord to secure the tenant’s lease obligations.
(ii) Important Distinction: Small security deposits are not true credit enhancement. A small cash security deposit or a month or two of rent, really constitutes Landlord claiming some leverage over the tenant when encountering smaller points of dispute; they do not address the credit risk associated the tenant’s potential inability to meet its obligations under the lease.
(b) Positive Features:
(i) Conversion to cash is easy.
(ii) Value is easy to determine up front.
(iii) Value is consistent over time (compare/contrast with a guarantor, for example).
(iv) No administration or monitoring.
(c) Drawbacks:
(i) Limits on amounts tenants typically can/are willing to post.
(ii) Security Deposit is part of the Tenant/Debtor’s Bankruptcy Estate: [3]
(A) Any cash security deposits not applied against lease obligations before the time of a Bankruptcy filing are subject to the automatic stay.
(B) Cash security deposit cannot be applied against rent amounts in excess of the §502(b)(6) cap on damages.
(d) Bankruptcy Side Note: The BR courts will generally treat a LL holding a cash security deposit in a manner similar to a “secured creditor.”[4]
5. Guaranty:
(a) What is a Guaranty?
(b) Positive Features:
(i) Typically uncapped in amount of security – most guaranties cover all obligations.
(ii) If Guarantor stays out of BR, the guaranty obligations will not be subject to the §502(b)(6) cap on damages.[5]
(A) HOWEVER: If Guarantor files for BR, then the cap does apply.[6]
(c) Drawbacks:
(i) Guarantor’s credit-worthiness may change over time.
(ii) Can be expensive and difficult to enforce the guaranty – not easily converted to cash.
(A) Must sue to convert.
(B) Does not get away from the Tenant’s defenses – Guarantor has a right to raise the tenant’s defenses under the lease.
(C) Suretyship law defenses, on top of lease defenses (poor administration errors).
(iii) Automatic stay – straddles line between pro and con. Bankruptcy court case law is sufficiently muddled on the matter such that cannot guarantee that, even if the Guarantor stays out of BR, the guaranty won’t be subject to the automatic stay.[7] It is probably “unlikely” to be subject to the stay, but there is clear precedent for the courts delaying enforcement of a guaranty in connection with a tenant’s BR, whether under the “automatic stay” concept (may be applied to non-BR 3rd parties under “unusual circumstances” – 11 USC §362) or other equitable powers of the court (“the court can and should enjoin suits by third parties against third parties if they threaten to thwart or frustrate the debtor’s reorganization efforts.”[8]).
6. Letters of Credit
(a) What is a Letter of Credit? A letter from a bank assuring payment of a certain amount if the conditions in the letter are met. When described in this manner, it sounds like just a guaranty, but being issued by a bank.
(i) The law does NOT treat Letters of Credit the same as it treats Guaranties.
(A) Guarantees are governed by suretyship law concepts developed by the courts and reflected in the body of common law cases that currently exist..
(B) LOCs are governed by UCC Article 5, a specialized code meant specifically to deal with LOCs. There are specialized sets of rules and practices for LOCs that have been adopted and used by parties to LOC transactions over time. [9]
(b) Why are Letters of Credit and Guaranties treated differently? This is a function of the history of how Letters of Credit developed and were originally used. There were two types of Letter of Credit:
(i) Commercial letters of credit: For a long period of time, these were used as a primary means of payment in international transactions. [Submit appropriate paperwork, and the “confirming bank” would honor the LOC issued by the “issuing bank” (the bank that issued the letter of credit). In other words, for a long time there was an expectation that the LOC is to be used as a primary means of payment.
(ii) Standby letters of credit. This type of Letter of Credit, while fundamentally the same as a commercial letter of credit, was not expected to be used as the source of payment by the parties. These would often require less documentary evidence.
(iii) Law followed the original use for Letters of Credit. Both types of letters of credit were treated the same by the law, and the law formed around the Letter of Credit’s original and primary use as a primary payment means for international transactions. By contrast, suretyship law (for Guaranties) was formulated in connection with the idea that Guaranties were a “secondary” obligation – the expectation is that the direct obligor will pay, and so the Guarantor is allowed to avail itself of all defenses of the direct obligor. [10]
(c) .How to Administer a Letter of Credit
(i) Renewal. Term of the typical Letter of Credit is likely not going to be as long as the lease term (typically 1 year). LL must monitor upcoming expirations and be able to draw on the Letter of Credit if it is not renewed.
(A) Evergreen LOCs. Automatically renew – BUT the lender may still elect to not renew. Must be permitted to draw if issuer gives LL notice of an election not to renew [and need to ensure Lease allows LOC to be changed so that issuer has proper address of LL at all times for delivery of notice of non-renewal].
(ii) Need to keep track of the original LOC to enforce it, generally. Going to get into this in more detail below, but must present original unless agreed otherwise– so don’t want to lose it. (ISP98 §3.12(a))[11]
(iii) Transfers: Maximize transferability WHY? Obviously, if you ever want to sell the building, need the LOC to go on to the next owner(s).. HOW? (1) Cap transfer fees in LOC terms; and (2) Expressly permit multiple transfers – (i) UCC/ISP/UCP all do not allow transfers of LOCs unless the LOC expressly permits a transfer; and (ii) UCP limits parties to only 1 transfer of an LOC; ISP does not contain this restriction).
(d) Enforcement (“Presentation”):
(i) Original. Under all applicable rule schemes (UCC/ISP/UCP), the original LOC must be presented for payment together with all applicable ancillary documents unless the LOC expressly allows otherwise (under ISP 3.06(a))– but the Banks are not going to let you do it, typically)..[12]
(ii) Delivery / Presentation. Under the ISP, presentation does not need to be in person.[13] This would seem to remove the need for a local Bank issuing (or confirming) the LOC, but two MAJOR RISKS with a distant Issuer – (i) risk of putting the only original LOC in the mail, and (ii) jurisdiction and enforcementissues exist in connection with far-away issuers.
(A) Jurisdiction and Venue/ Local Confirming Bank:
- Where will a dispute about the LOC be adjudicated if you accept a distant Issuer?(Disagreement on timing or expiration; proper submission; other issues.) The parties to the LOC can select jurisdiction and venue, per UCC 5-116. However, enforcement issue exists if the issuer has no assets in the state having jurisdiction.
- Parties may wish to identify a local “confirming” bank that assumes the issuer’s obligation to pay on the LOC.[14] [Negotiation Tip: Ensure LOC is issued by an institution with a local branch/location that allows presentation at its local offices, or confirm the LOC will be “confirmed” by a local bank. Have LOC state where LOC must be presented for payment (or else presentation will be at place of issuance – ISP §3.04).
(iii) Conditions to Payment. These are what you make them! (but must be documentary). “NON-DOCUMENTARY CONDITIONS” (conditions that don’t involve delivery of a document) IN LOCs ARE NOT VALID. UCC 5-108(g))[15]
(A) LL will want payment upon presentation of the original LOC (a “sight draft”) AND NOTHING ELSE.
(B) Tenant will want presentation documents to include an affidavit to Bank that Tenant is in default. [Why an affidavit – establish liability, and deter over-aggressive draw.]
(e) Pros of LOCs:
(i) Convertibility to cash. An irrevocable LOC that can be drawn simply upon certification by LL at a local confirming bank is the next closest thing to having cash collateral, in terms of.
(ii) LOC issuer has an independent obligation to the LL under the LOC, apart from the terms of the underlying lease the LOC secures (The “independence principle”). Payment on a “Sight Draft” Standby LOC will not be deterred by dispute under the lease (provided tenant sign-off and an affidavit are not required…).
(iii) .Draws on LOCs are not subject to a BR automatic stay, as funds are not part of the BR estate.[16] (Query if this will stand in jurisdictions deeming an LOC to be an asset of the BR estate…) Caveat: Avoid having conditions to draws on LOC in the lease, which could trip up ability to draw on LOC.
(iv) Lender takes the “credit risk” with respect to the Tenant.
(v) For tenants with ample capital or assets, they only pay a fee to the lending institution without tying up working capital. [Smaller tenants may need to tie up assets as collateral for the LOC, and the fee may be more costly, thus negating this “benefit.”]
(f) Cons of Letters of Credit:
(i) Complexity.
(ii) Difficulty in administering.
(iii) Transaction costs. (Transfer fees; issuer fee on LOC; cost of administration; etc.).
(iv) Post-Great Recession – one may wish to assess creditworthiness/financial stability of the issuing lending institution.
(g) Bankruptcy Consideration – §502(b)(6) Cap getting shakier: DESPITE PAST THINKING ON THE MATTER – LOCs should still serve as a way around the cap if the LOC exceeds the cap (i.e., in making your claim against the Issuer – see In Re Stonebridge).
(i) EQUITABLE POWERS OF THE COURT used to stop LOC draws in some cases. In re Prime Motors, for example. Also, minority courts deem the LC and proceeds to be part of the estate/subject to the court’s powers.
(ii) DERIVATIVE QUESTION – DO THE LOC’s PROCEEDS GET APPLIED AGAINST THE CAP IF YOU FILE A PROOF OF CLAIM? If you want to get additional funds up to the Statutory Cap, do the LOC proceeds offset? Mayan Networks says YES on the idea that the structure was merely a way around looking like a security deposit, which is a VERY SHAKY proposition..[17]
(iii) Can the Bank subrogate to the Tenant’s rights to the 503(b)(6) cap and sue to get the funds back in excess?
[1] 11 USC §362. http://www.law.cornell.edu/uscode/text/11/362
[2] 11 USC §502(b)(6)). “(A) the rent reserved by such lease, without acceleration, for the greater of one year, or 15 percent, not to exceed three years, of the remaining term of such lease, following the earlier of–(i) the date of the filing of the petition; and (ii) the date on which such lessor repossessed or the lessee surrendered, the leased property; plus (B) any unpaid rent due under such lease, without acceleration, on the earlier of such dates.” SIDE NOTE (ONLY IF RAISED BY A Q): A landlord has a claim for all unpaid pre-petition amounts due plus late charges and interest accrued on those amounts up to the bankruptcy petition filing date. The Bankruptcy Code puts no limit on the amount of this claim. [Example: LL exercises cure right and charges tenant for the cost of the work. Not capped. Must file a proof of claim, however, to collect.]
[3] Any application of the deposit (or offsetting of Landlord’s obligation to return the security deposit under 11 USC 553(a)) will be subject to the automatic stay and §502(b)(6) cap on damages. See Oldden v. Tonto Realty Corp., 143 F.2d 916 (2nd Cir. 1944); and 11 USC §553(a).
[4] How the BR courts arrive at that conclusion has varied by jurisdiction. In Oldden v. Tonto Realty Corp., 143 F.2d 916 (2d Cir. 1944), LL was permitted to deduct the security deposit from its allowed claim, with surplus returned to the debtor. In ITXS, Inc. v. F&S Hayward, LLC, No. 03-3082-MBM, slip op. at 8 (W.D. Pa. Dec. 13, 2004), the court held that the LL has a perfected lien/security interest in the security deposit. In In Re Johnson, 215 B.R. 381, 384 (Bankr. N.D. Ill. 1997), the court held that the LL effectively held a non-judicial lien on the security deposit. In In re Northeastern International Airways, Inc., 99 B.R. 487, 488-89 (Bankr. S.D. Fla. 1989), addressed perfection of the security interest in the security deposit by possession. Other courts allow the obligation to return the deposit to be offset against any amounts due from the debtor/tenant under 11 USC 553(a).
[5] See 11 USC §524(e) – “(e) Except as provided in subsection (a)(3) of this section, discharge of a debt of the debtor does not affect the liability of any other entity on, or the property of any other entity for, such debt.” See also, Kopolow v. P.M. Holding Corp., 900 F.2d 1184; and Bel-Ken Assoc. v. Clark, 83 B.R. 357.
[6] For a discussion of capping the liability of a bankrupt guarantor under §502(b)(6), see In re Episode USA, 202 B.R. 691 (“The court sustained debtor’s objection to the claim because it determined that on its face, § 502(b)(6) neither included nor excluded guarantors from its application. It merely stated that any claim of a lessor for damages resulting from the termination of a lease of real property was subject to the statutory cap. The thrust of the § 502(b)(6) cap was not directed toward any particular debtor-entity; rather, it acted to limit the amount of damages the lessor might be allowed from bankruptcy estate assets.” – Lexis summary of decision)
[7] See “Revisiting the 24 Defenses of the Guarantor – 24 Years Later”, J. Stein, The Practical Real Estate Lawyer, January 2012, pp 9-26 for a discussion (“Defense 24: Automatic Stay” on page 26).
[8] In re Granite Partners, L.P., 194 B.R. 318.
[9] Rules and Practices: Different sets of rules and practices surrounding LOCs also exist; most common are: 1. International Standard Practices 1998 (ISP 98) from Institute of International Banking Law and Practice (more U.S. oriented). [Other, less used one – Uniform Commercial Practices (UCP 600; 2006 revision by the International Chamber of Commerce – more internationally oriented drafting) ] 2. UCC 5-116(3): Except to the extent of any conflict with the non-variable provisions of UCC Art. 5, this section will make the ISP/UCP rules and practices trump the UCC Article 5 (if such rules are selected in the LOC), in event of conflict, unless LOC expressly provides otherwise. So, LOC should state which rules/convention apply AND whether or not the convention trumps in the event of a conflict. (B). Governing Law (State): Unless applicable law is expressly set out in the LOC, governing law is based on the location of the issuer.
[10] A comparative example of the difference: “A guarantee is secondary and a letter of credit primary in the sense that the guarantor can assert the defenses of the person whose liability it guarantees, whereas the issuer of a letter of credit may not look to the underlying transaction for defenses.” Put that into practical terms: A guaranty on the other hand – the conditions to payment may occur (default beyond applicable notice and cure periods under the Lease), but if the Tenant has defenses that it can raise against having to pay Landlord its damages under the Lease, the guarantor can avail itself of those defenses as well. The obligation under the guaranty is secondary to (basically conditioned upon) the rights and obligations existing under the Lease.
[11] Risk mitigation approach: Require the Lender to replace lost LOCs (why lender? Because the Tenant (i) no longer has the collateral backing it up, if you have to default them for failing to get a new LOC, and (ii) you’re out of luck if the Tenant can no longer obtain an LOC at that future date.
[12] ISP §3.06(a) and (b) allow for the idea of electronic presentation or other forms, as selected by the parties provided LOC expressly permits by its terms (otherwise, paper document is presumed to be required). See “Drafting Letters of Credit”, Jeffrey S. Wood, Banking Law Journal, February 2008, p 103; see p 134 for discussion of electronic presentation. For a discussion of lost LOCs, solutions and why the requirement of presentation of originals is generally foolish, see: http://www.mosessinger.com/site/files/ISP98Rule312(a)AndLetterOfCredit.pdf
[13]See ISP §3.02, permitting presentation by mail.
[14] See ISP §1.11 and definition of Confirmer.
[15] Negotiation tips: Make LOC drawable (i) upon LL certification that amounts are owing without any other requirements or tenant cooperation, (ii) in any amount up to the entire amount (to avoid having to make multiple draws – but in any event be able to draw entire amount if multiple draws prohibited), and (iii) up to 91 days after the date of Lease termination (to allow LL to draw on the LOC in the event of a preference claim against the rent paid by Tenant with in the preference period after the lease ends).
[16] See In Re Farm Fresh Supermarkets of Maryland, Inc., 257 B.R. 770 – MD courts confirm automatic stay doesn’t apply.
[17] See EOP-Colonnade of Dallas Ltd. Partnership v. Faulkner (Stonebridge Technologies, Inc.), 430 F.3d 260 (5th Cir. 2005) for a court decision that an LOC is not subject to the cap (provided LL has not filed a proof of claim against the BR estate – which is problematic as the debtor/BR trustee can file the proof of claim for the LL/creditor under §501(c)). Conversely, see In re PPI Enterprises, 228 B.R. 339, 350 (Bankr. D. Del. 1998) aff’d, 324 F.3d 197 (3rd Cir. 2003)., In re Mayan Networks Corporation, 306 B.R. 295 (B.A.P. 9th Cir. 2004), and MB Properties, L.P. v. Official Committee for the Estate of AB Liquidating Corp. (In re AB Liquidating Corp), 416 F.3d 961 (9th Cir. 2005) for the most recent slew of cases subjecting LOCs to the §502(b)(6) cap under varying legal theories.